The Case for a Correction in Stocks - views

BALTIMORE (Stockpickr) -- Up, up and away has been Mr. Market's modus operandi in recent months, shoving its way to new all-time highs as this past year came to a close. And all the way up, the bulls and bears have been arguing over why the rally was justified -- or why it wasn't.

But that doesn't mean that now's the time to jump into stocks. Instead, markets look overdue for a meaningful move lower this month.

I've made it no secret that I'm bullish on stocks. Since I gave my reasons for expecting a secular bull market, the S&P 500 has added a 30% premium onto its price tag. And it's still got a lot further to go before it reaches my (very) long-term target.

Yes, I realize those two ideas sound contradictory. How can stocks be headed lower if they're also headed higher? But bear with me, and I'll show you how a correction this month could provide a big opportunity for your long-term stock portfolio.

Expecting long-term upside isn't the same thing as saying that stocks are going straight up from here ad infinitum. Corrections are a necessary part of a healthy market rally, as risk-averse early investors take gains off the table, and later investors jump into shares at relative lows.

And right now, there are a handful of fundamental and technical factors that point to a correction happening sooner rather than later.

Stocks Are Expensive-ish

When investors talk about stocks being cheap or expensive, it's not an absolute term. Obviously, with the big indices sitting at new highs, stocks in general cost more than ever before. But what makes a stock cheap or expensive is its cost relative to what you get for that price tag: metrics such as earnings or assets.

With a price-to-earnings ratio of 18.88 in the S&P 500, stocks still aren't truly expensive. But they are starting to look expensive-ish.

In the last year, the P/E ratio for the more growth-oriented Nasdaq 100 Index has increased 31%. Basically, that indicates that investors are paying a lot more for the same earnings power than they were just 12 months ago. Two things can happen to make stocks look cheaper again based on P/E: either share prices drop, or earnings increase.

It's important to remember that, on a historical basis, the P/E ratios on the market averages aren't at insane levels right now. The S&P would need to rally to 3,115 tomorrow to reach the peak P/E ratio the index hit during the dot-com bubble.

But valuation metrics have moved far enough and fast enough to warrant a correction.

As I mentioned, the other side to that valuation equation is earnings -- and with earnings season officially kicking off this week, there's a big multi-month catalyst that could help take some of the froth off of valuations in 2014. If stock prices let off some steam and earnings best analysts' expectations, stocks could suddenly look cheap again.

Technical Time to Correct

While the fundamentals can tell us a lot about whether stocks look cheap or expensive right now, aren't as useful at timing where and when important price changes are likely to occur. For that, we need to add technicals into the equation.

From a technical analysis standpoint, it doesn't get much more textbook than the rally we've seen in the S&P 500 for the last year and change. Take a look:

The S&P has been bouncing higher in an uptrending channel, with corrections that came down to test support in between each rally leg. It's notable that we haven't seen a full correction back down to trendline support since all the way back in October -- the most recent leg down stopped at the 50-day moving average thanks to a Santa Claus rally and intervention from the Fed. That makes this the second-longest stretch since this rally began in 2012 where we haven't had a pullback to the bottom of the channel.

Even though the S&P hasn't touched trendline resistance yet, shares have remained in the upper-third of the channel long enough to warrant a return to support.

This is very much a "buy the dips" market. Jumping into stocks at each test of support has been a lucrative strategy all the way up -- and it's likely to remain that way as we get deeper into 2014. That fact makes a correction in the S&P a critical buying opportunity for investors waiting for a good chance to get in.

A break of the RSI uptrend line is likely to be an early warning sign that we're going to get our correction. A timing model I've been using with success for the last year and change puts the correction this month. Barring some catalyst that surprises the market in the next few weeks, a push to new highs before the month is out looks unlikely.

The next buy signal for stocks comes on a bounce off of trendline support.

How to Win When Stocks Correct

You don't have to just hang on and take downside as the S&P heads into corrective mode. Instead, it makes sense to actively position yourself to profit from it.

Why bother re-allocating your portfolio if a stock correction is likely to only last a few weeks? In short, it's because the names that thrive during pullbacks are the same ones that rocket when equities go back into rally mode.

But there's nothing wrong with defense. After all, that covers the fundamental side of the correction equation. And believe it or not, there are still some names on the market today that you can buy at a big discount.

Look at Garmin (GRMN) for example. The GPS maker currently trades for a P/E ratio of 15.2, but that number does a poor job of conveying just how cheap GRMN is right now. It doesn't factor in the $2.79 billion in cash and investments on Garmin's balance sheet (and zero debt), which is enough to pay for nearly 32% of GRMN's outstanding shares at current price levels. Take out cash from that P/E ratio, and it suddenly drops to a measly 10.

Better, Garmin's dividend yield currently comes in at more than 4%. Calling Garmin a defensive name is an understatement.

Most people think that the best way to position yourself for downside is by focusing on defensive names -- but that's not the only way to cut downside risks. Statistically, it's the momentum names, not the defensive ones, that provide the most upside potential.

When the big indices are correcting, relative strength becomes the single most important metric in your toolbox. Relative strength is the ratio between a stock's price and its benchmark. When the line is rising, the stock is outperforming.

More important, rising relative strength statistically tends to lead to more stock outperformance. In other words, it's the gauge that tells you which stocks are going to work the best.

Big relative strength names right now include Micron Technology (MU), Alcatel-Lucent (ALU) and Herbalife (HLF). What most relative strength winners lack in deep value, they make up for in upside momentum. After all, who cares if a stock is expensive as long as it gets more expensive before you sell it? Just remember to keep tight stops in place.

So don't fear the coming correction. Owning a combination of defensive names and stocks with uptrending relative strength puts you best positioned for the pullback that's on the way. This is still very much a "buy the dips market." We've just got to wait for the next dip.

Jonas Elmerraji, CMT, is a senior market analyst at Agora Financial in Baltimore and a contributor to TheStreet. Before that, he managed a portfolio of stocks for an investment advisory returned 15% in 2008. He has been featured in Forbes , Investor's Business Daily, and on CNBC.com. Jonas holds a degree in financial economics from UMBC and the Chartered Market Technician designation.